Picture if you and a friend are at the circus, and you see a person walking on very tall stilts. Suddenly you can tell he’s in a lot of trouble – he’s shaking, his arms are flying around, he’s experiencing “height volatility”, he looks like he’s going to collapse at any second. Now imagine your friend goes up close and says “You know, the left stilt looks more wobbly than the right stilt.” That would be missing the forest for the trees, right?

I feel that way with discussions of the Mancession. Pointing out that one member of a household is more likely to lose their job than the other member ignore the serious problem that households have evolved to the point where either earner losing their job will collapse the entire structure.

Since the 1970s, family households have taken on an additional earner, but have less discretionary income. Why is this? Warren finds that fixed household expenditures have taken on a much larger percentage of the budget. This isn’t Warren trying to find a dark cloud to go with a silver lining. The business analyst in you should be jumping up in their chair – we see that the middle class household firm has maxed it’s production but that additional earnings has gone straight into debt and fixed costs. Like Walmart’s low employee cost is a great business strategy but it can also be a liability – in a recession, laying off people won’t make a huge difference because labor costs are so low. Discretionary spending is so low that if one earner loses their job reducing it won’t make much of a difference. And there are a lot of people losing their jobs.

Pricing CDS Contracts on the MIddle-Class

Let’s look at the Merton Model of credit risk:

Here is an awesome crazy mofo explaining how this equation becomes the likelihood of default. This is the d2 of the Black-Scholes equation, a handy quant tool. The smaller the number is, the more likely it is you’ll have a bankruptcy event – the more risky the firm is. (If you multiple it by -1 and slide it under the normal distribution, you get how much you should charge to sell a CDS. Trust it?) The equation gives us a sense on some drivers of risk. And Warren’s research gives us a sense of how S and K have evolved.

S is assets; they are down, both because the savings rate is low and whatever savings has been going on in household appreciation is gone. S being down raises the risks of default. K is debt and fixed costs; as we can see from the graph above, debt takes up a majority of household income; if either earnings center goes under debt will be difficult to manage. Debt has also become increasing in volatile and high-interest credit card debt – the nature of the debt itself is become more risk prone. Ezra Klein is right to focus on the debt of households when it comes to a lead-in to the financial crisis. When you dig down another layer into that debt, you see that it is setting-up the structure of the current household in a way that makes it incredibly prone to collapse. Debt going up increases the risks of default.

We have two variables left; r, for the expected rate of increase in wages, is near 0 for some time; wage increases are flat. Sigma, or the volatility of income and appreciation of assets, is up. Indeed, as the work of Jacob Hacker shows, it has doubled between the 1970s household and 2000s household. That jacks up the riskiness of the household (decreases the numerator, and increases the denominator) at the same time, and makes it more likely we’ll end up below the default threshold.

All of these variables have been trending towards more risk over the past 30 years, and certainly towards more risk in the past 12 months. All said, the real story of the crisis isn’t necessarily one sector over the other; it is that the middle-class, looked at with financial engineering googles, is pushed towards the edge of risk. This wave of bankruptcies has already begun, even with the new bankruptcy rules. The government should been putting in mechanisms to make the process of bankruptcy, which will mitigate how a lot of the Recession recovery plays itself out, move smoother. Things like mortgage cramdowns, for instance.

How Does Inequality Come Into Play?

Why has this happened? We are going to talk about Will Wilkinson’s new paper on inequality next, so we want to see if any of this new household fixed costs are driven by this. Going back to the first chart, the increase in fixed spending has occured across several specific issues. (1) A second car payment, and a slightly larger car payment per car. (2) Health insurance. (3) Housing. Not having a giant household per se, but a household that is targeted to school districts and safe neighborhoods.

We know what drives some of this. The increase in health insurance is a separate literature in itself, but nobody would disagree with that. The household needs a second car because it is likely they live in a place where public transit isn’t even an option.

What has gone on with housing is going to be a big topic of research for a long time. I wasn’t sure on this competition as a driver of spending on households until Will’s paper pointed me in a specific direction. “Morreti finds that half the increase in the college wage premium disappears when the housing costs borne by college grads are taken into account, and suggests that “the increase in well-being inequality between 1980 and 2000 is smaller than the increase in nominal wage inequality” on the basis of this fact alone.”

So that research shows that a large part of the premium that comes to wages from college education goes straight into bidding over housing. Think of your friends from college – some are making bank, some aren’t. Some are teachers, some are engineers, and some are in finance. But they all have to bid on the same housing stock. It strikes me as there being a big dodge in saying that increased bidding on housing has no impact on well-being inequality, as the location of where college-educated settle drives a lot of the growth of the economy. This is where inequality can drive instability.

Clark – it is the continuously compounded rate. S/K is the ratio away from in-the-money that we are when we start. For the purposes of credit risk models here, if you have $2,000 in the checking out, and you need to pay $1,000 for debt, you are ln($2,000/$1,000) away from going into bankruptcies, continously compounded. Notice that the larger this value, the less likely it is you default – it is larger if you have more money in hand, or less debt.